Financial Markets
Incentives for self-regulation

The rationale for regulating financial services is different from that of banks. Bank regulation is associated with the fear that a run on deposits will spread contagiously through the system, and such systemic risks do not in general apply to financial institutions that merely advise clients on portfolio administration and or to brokers effecting transactions on behalf of others. Market failure for such firms is associated with imperfect information on the part of investors, who find it difficult to discriminate between high- and low-quality firms ex ante, so that the high-quality firms will not get appropriate rewards for their service and the average quality of firms may decline. Similarly, investors cannot avoid the risk of fraud ex ante.

In Discussion Paper No. 429, Programme Director Colin Mayer and Research Fellow Damien Neven analyse the design and implementation of financial regulation and assesses the EC Commission's current proposal concerning capital requirements for financial intermediaries. They focus on two regulatory instruments: penalties for misconduct and capital requirements, where `capital' comprises not only all the assets that a regulator can expropriate but also the goodwill associated with a firm's reputation and industry-specific training, which will typically be extinguished misconduct is revealed.

Their results indicate that capital requirements are more useful when there is a relation between the quality of firms and their capital and that the right mix of instruments is quite sensitive to the structure of the industry. In particular, investment managers pose relatively few risks to investors and their quality can be evaluated fairly easily. The regulation of these firms should rely on the imposition of hefty penalties in case of misconduct and they should be required to separate clients' funds from their own. In contrast, market-makers in equities handle large amounts of money and securities, and their regulation should be based on capital requirements. They therefore argue that the early attempt by the European Commission to impose common capital requirements on all investment businesses was probably misguided.

Mayer and Neven also argue that self-regulation will be feasible where the potential losses are modest and members of the organizations have large amounts of invested capital. In the UK context, therefore, self-regulation is inappropriate in the case of the Financial Intermediaries, Managers and Brokers' Association (FIMBRA), which draws its membership from independent investment brokers, managers and advisers, but it is more appropriate for the Investment Management Regulatory Organization (IMRO), which mainly comprises investment managers employed by larger companies.

European Financial Regulation: A Framework for Policy Analysis
Colin Mayer and Damien Neven

Discussion Paper No. 429, July 1990 (IM)